The Rising Cost of College
Tuition and
the Effectiveness of Government
Financial Aid
by

David W. Breneman
University Professor and Dean
Curry School of Education

February 9, 2000

Testimony
for the
Committee on Governmental Affairs
United States Senate

Members of the Senate Committee on Governmental Affairs:

I
am pleased to have been invited to testify before your committee
on the vexing questions of college costs, affordability, and the
effectiveness of federal student aid programs. As one of a small
number of economists who specialize in this area, I receive phone
calls every week from news reporters seeking comments on these topics,
so I know they are of interest and concern to millions of Americans
with children approaching the age of college. It is also clear,
however, that the reporters' concerns are focused on a relatively
small number of the highest priced private colleges and universities,
enrolling a tiny share of the nation's college students. Never
have I been asked about the high price of community colleges, which
enroll over 43 percent of all undergraduates. Rarely am I asked
about the rising cost of public colleges and universities, which
enroll over 37 percent of all undergraduates. And within the remaining
20 percent of undergraduate enrollment, the concern is directed
to those highly selective institutions at the top of the pecking
order that may enroll only two to three percent of all undergraduates.
The news stories written about those top schools filter down and
create a sense of panic on the part of many parents who will never
consider such schools, which makes one wonder whether this issue
is more one of perception than reality. But, as we all know, people
often act on their perceptions, and the polling data do show that
the high cost of college is the main concern parents have about
higher education. The question for this committee, I assume, is
what, if anything, can or should the federal government do to respond
to these concerns.

In
my judgment, economist Howard Bowen came closest to giving us a
good statement of what determines college costs. Bowen argued that
revenues determine costs, in that colleges and universities raise
as much money as they can, and they spend it as wisely as they can
on the multiple activities of teaching, research, and service.
Bowen's concept is known as the "revenue theory of costs," and it
emphasizes the fact that no absolute, objective standard exists
by which we can say how much college should cost. Institutions
index every financial variable to the outlays of a peer group, and
judge themselves by where they are in that relative ranking. U.S.
News and World Report has reified this relative ranking game into
its highly influential annual report on the Best Colleges and Universities,
which tends to reinforce what economist Gordon Winston has called
higher education's "positional arms race."

An
additional aspect of higher education finance that complicates the
picture is that most institutions have numerous sources of revenue:
state (and local) appropriations, state student aid funds, federal
student aid funds, research grants and contracts, gift income, endowment
income, income from auxiliary enterprises (hospitals, dormitories,
bookstores), and, of course, tuition. When one revenue source declines,
administrators search for another one to increase. So, for example,
when state appropriations drop, as they did significantly in the
early 1990s, institutions responded by raising tuition and increasing
private fund raising.

This diversity of revenue streams is where the oft-cited analogy
of higher education to health care breaks down, because higher education
does not have a single dominant source of revenue that operates
as the third-party insurance source does in health care. Hence,
it is simply wrong to use the health care analogy to argue that
federal grant aid helps to drive up tuition. Federal grant programs
are income-tested such that, in virtually all cases, a student's
grant does not rise as tuition increases. The case with federal
student loans is a less clear, and hotly contested. I have not
seen a definitive study on this issue. Most federal loans programs
are capped, but with the addition of numerous private loan programs,
plus home equity loans, it seems plausible to me that the availability
of loan finance has made it easier for some institutions to raise
prices. But even if that were the case, the remedy is not clear.
It is hard to believe that parents would welcome a decision by the
federal government to curtail severely their access to loan capital
for investments in higher education.

I
should note that many of us believe that the federal tuition tax
credits, enacted and proposed, do set up an incentive for state
governments to raise public tuition high enough to qualify for the
full credit, and for private colleges and universities to offset
some of the credit against institutionally funded student aid, effectively
raising their net price to students.

Separate
analyses of tuition setting are required for the public and private
sectors of higher education. Tuition prices in public colleges
and universities are politically determined prices that may bear
little, if any, rational connection with underlying costs. Essentially,
the share of costs borne by tuition is a political decision about
how to allocate the burden between students and the general taxpayer.
For the last 20 years, the trend has been for the student to bear
a growing share of the cost, as states have reduced the share that
they cover. Periodically, a governor or legislature may conclude
that tuition has increased too rapidly, and will buy down some of
the tuition increase with state funds--this has happened recently
in California, Massachusetts, and Virginia. But my essential point
is that I see no role for the federal government to play in state
decisions about public tuition, other than to be aware of incentives
that federal programs, such as tuition tax credits, may create.

Within the private college and university sector, state policies
and programs have less influence, and the market becomes the principal
arbiter of prices charged. But the private sector is far from monolithic
in its financial circumstances. The majority of private colleges
and universities struggle each year to make ends meet and, in some
cases, to survive. Many of them discount their stated tuition deeply,
40 percent or more, so that the actual net price that a student
pays is well below the posted price. A few of these colleges have
tried cutting tuition, and others have frozen it, but in most cases,
they know that a three or four percent tuition increase will be
eaten up to a significant degree by increased student aid discounts.
These colleges are running hard just to stay in place, and I see
no public purpose served by having the federal government attempt
to interfere with their pricing.

This
brings us to that tiny set of private colleges and universities
in which the media invest so much attention--the 50 or so institutions
that have enormous wealth. Endowments are very unequally distributed
among colleges and universities, and those with the most to start
with have experienced phenomenal gains in this bull market. Indeed,
one has to modify Bowen's revenue theory of costs in two ways for
these institutions: They do not raise all that they can, and they
increasingly save much of it through transfers to endowment. They
do not raise all that they can because, with the huge applicant
pools that they have, they could clearly charge even higher prices.
They do not spend all that they raise because, with endowments growing
at 20 percent or more, and spending rates of 5 percent or so, the
remaining gain more than compensates for inflation. Williams College,
one of the members of this wealthy group, recently announced it
would not raise tuition in the coming year because of sizable endowment
gains. I believe this is an attempt of one college to send a signal
to its peers that this group would be wise politically to break
the pattern of steady tuition increases. (Appended to my testimony
is an essay I prepared for the Chronicle of Higher Education on
the Williams College decision.) I submit that if the federal government
has any useful role to play in the area of college costs and prices,
it might come in helping these few wealthy colleges to mitigate
the "positional arms race" in which they are engaged. The 1989
anti-trust case against these colleges has limited their ability
to discuss what they, as institutions operating in the public interest,
can and should do about the new economic circumstances in which
they find themselves. Allowing that discussion to go forth is my
best recommendation for action coming from these hearings.

Finally, what about the students? Your hearings tomorrow focus
on student aid, but let me note that family income is still the
major determinant of who goes to college, and where. In the rush
to provide tuition tax credits, prepaid tuition plans, and tax benefits
for college savings, we forget that most low income families cannot
avail themselves of these programs. Furthermore, once enacted,
these plans, like guaranteed student loans, operate as entitlements,
whereas the Pell Grant program remains subject to annual appropriations.
We are in danger of severely altering the fundamental focus of federal
student aid, which should remain concentrated on helping students
from low income families pay for college. Were I testifying tomorrow,
I would recommend that Pell Grants be turned into an entitlement
program, so that low income students have assured support at a time
when billions of state and federal dollars are helping middle and
upper income families pay for college.

Thank
you for giving me an opportunity to present these thoughts to the
committee.

APPENDIX
I Chronicle of Higher Education
From the issue dated Fe. 11, 2000

POINT OF VIEW

A
Tuition Freeze Accents the Cockeyed Economics of Higher Education

BY
DAVID W. BRENEMAN

The recent decision by Williams College to freeze its tuition and
fees for the 2000-1 academic year prompts reflection on the cockeyed
economics of higher education -- and just how hard it is to do the
right thing in our enterprise.

When
a profit-making business cuts its prices, or holds them steady in
the face of increases by competitors, the reason is usually to gain
market share. When Northwest Airlines, for example, refuses to follow
the price increases announced by other airlines, its motivation
is to attract customers away from those airlines.

That
is clearly not the motivation of Williams College, however. It already
has around 5,000 applicants for the 500 positions in the entering
class, and it is not seeking to expand.

Perhaps,
then, the college's motivation is to attract higher-quality students.
That does not seem to be a plausible explanation either. The modest
reduction of Williams's price next year relative to its peers --
assuming that they do not match the tuition freeze will probably
not cause students to opt for Williams over colleges that they might
prefer. If Williams wanted to attract particular students, a targeted
approach using merit aid would be far more effective, and less costly.

In short, it is difficult to see any institutional self-interest
operating in the decision by Williams. Why, then, did such an action
take place, particularly at a college where the influence of economists
is unusually strong in the management of the institution?

The
college's explanation was simply that big increases in charitable
gifts, along with the remarkable growth of its endowment, meant
that Williams could afford to provide stable tuition for at least
one year. Although I accept that explanation at face value, it doesn't
tell the whole story. The decision must be seen in the context of
three forces that have been operating on higher education in recent
years.

First,
this decade's buoyant economy, sharply rising stock market, and
limited inflation have generated enormous gains in wealth for the
colleges and universities with strong traditions of private support
and large endowments. Historically, endowment gains have averaged
9 to 11 percent annually, and inflation has run about 4 to 5 percent,
with spending rates from endowments holding at around 5 to 6 percent.
The result has been to keep endowments roughly constant in real,
or inflation-adjusted, dollars. In recent years, however, with endowment
gains exceeding 20 percent, inflation at 2 to 3 percent, and spending
rates unchanged or even reduced, the increase of wealth at the top
private institutions has been enormous. The Williams decision is,
in part, a response to that new fact of life.

Secondly,
a growing desire by talented students to attend those wealthy institutions
has prompted increasing demand for admission, despite high and rising
prices. Indeed, given the excess demand for enrollment, the true
economic question is, why haven't prices gone up faster than they
have?

Nonetheless,
the rising sticker price of college, especially at elite private
institutions, has prompted the news media to promulgate endless
critical articles decrying tuition increases, and the US Congress
to appoint a national commission to explore ways to contain college
costs and prices. Thus, the third, and perhaps most influential,
force is that the high price of college, real or perceived, has
become every parent's nightmare. And it has produced political responses:
the Clinton tuition tax credit, and the tuition freezes that several
governors have imposed on their public universities, to cite just
a few.

Such
forces explain the Williams College decision as an effort to exercise
by example a type of price leadership, one that responds to the
barrage of public criticism about higher education's endless increase
in prices despite new economic conditions. I find it hard to fault
that motivation. We in higher education urgently need to discuss
issues surrounding rising college tuitions among ourselves and with
our key constituencies, and to reevaluate our tuition policies.

Yet
the dilemma is that a public conversation about those issues is
very difficult to have. In fact, I suspect that most of Williams's
peer institutions and other private colleges will ignore the decision,
and avoid discussing it with parents and other constituents as much
as possible. Why? Because, for peer institutions, it is economically
unnecessary and, for less-wealthy institutions, economically disadvantageous,
to discuss it, much less follow Williams's lead.

Williams is a tiny part of the market, and the effect of its freeze
will go largely unnoticed in the competition for students, imposing
no real penalty on its competitors -- the other top 30 or 40 private
colleges and universities. Furthermore, many presidents will see
the action as undercutting the rationale for fund raising, if the
institutions implicitly admit that they currently are able to forgo
tuition increases. In the segment of the market in which Williams
operates, the decision to freeze tuition clearly leaves money on
the table, an unusual action for nonprofit as well as business enterprises.

For less-wealthy private colleges, the Williams action poses not
just a potential embarrassment but a real threat. Those institutions
do not have the same endowment resources as Williams and its peers,
and are therefore more dependent on tuition. If other top-tier colleges
follow Williams's example, institutions in the second tier will
be in a predicament. On the one hand, they will have lost the umbrella
of protection from public criticism provided by tuition increases
at all private colleges. On the other, many of them must continue
to raise prices, since they do not have the depth of nontuition
resources on which to draw. They will be in the difficult spot of
being damned if they do, and damaged if they don't. In short, the
Williams tuition decision -- rather than starting a much-needed
conversation about college pricing, wealth differentials in higher
education, and if and how public policy should respond to new economic
conditions -- will be seen within private colleges as an embarrassment,
a momentary slip, and a misbegotten attempt to discipline the market.

If
peer institutions do not follow suit, Williams will almost surely
be forced to resume tuition increases next year. And, within a couple
of years, the entire incident will be forgotten. Williams will have
suffered a one-time loss of revenue, a small but enduring penalty
for trying to change market behavior. The "positional arms race"
that drives our leading institutions will resume, and an opportunity
to clarify the public understanding of the economics of private
higher education will be lost.

It
will have been lost at our own peril. We can't operate solely according
to financial concerns; we must also consider our public trust. If
resentment and anger about higher-education pricing continue to
build, politicians may well find a way to lash out and do real damage
to our private institutions -- as they already have done in several
cases to our public institutions. Private colleges and universities
would be particularly vulnerable to changes in the tax code that
would restrict or eliminate significant tax benefits that they receive
through their designation as nonprofit organizations.

The leaders of Williams should be given credit for putting those
issues on the table, even if most college presidents wish they had
not and conclude that they have ultimately been foolish. The Justice
Department's antitrust case against colleges in the late 1980's
has brought a chill to conversations about how these hybrid institutions
-- nonprofit yet highly competitive like profit-making organizations
-- conduct their affairs. We need to revisit that antitrust decision,
and instead argue the need for open discussion about college tuitions
and the use of resources -- rather than relying on indirect signaling
methods, such as the Williams tuition freeze.

Whatever
our economic and political concerns, we can only bring about reforms
in how we finance and price our institutions by publicly considering
the issues together. We shouldn't pin our hopes on one college's
unusual act of courage and candor.

David
W. Breneman is university professor and dean of the Curry School
of Education at the University of Virginia. He previously served
as president of Kalamazoo College.

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